What happens when you sell a rental property and the gains exceed current year losses and suspended losses from rental property?

Are you familiar with “suspended passive losses?” Generally, with  a passive activity (e.g., rental property), losses each year are allowed to the extent of income unless the taxpayer qualifies under 469(i) as actively participating in the activity. (A full discussion of active participation is out of the scope of this blog, but will revisit it at another time.) Any excess losses are suspended until the taxpayer has passive income to offset those losses or disposes of the property.

While this is pretty straightforward with a single property, additional complexity arises when a  taxpayer owns multiple properties. A frequent question I get deals with a scenario where a client sells a rental property and the gains exceed current year losses and suspended losses from the rental property. Will those excess gains release some of the suspended passive losses from the other rental properties the taxpayer still owns? The answer is yes. The gains from the sale of the property are classified as passive income for this purpose. As such, they are used to offset additional suspended passive losses. The gains are included in the Net Income column of the applicable worksheet, which then flows to Part I of Form 8582, Passive Activity Loss Limitations. Here is a good example:

Bob Smith owns three rental properties that he has held for several years. Current year losses are as follows:

  • Whispering Pines – ($1,250)
  • Silver Creek – ($750)
  • Plum Falls – ($1,500)

He does not actively participate; therefor, over the years, his losses have been suspended. Prior year suspended losses from the properties are:

  • Whispering Pines – ($10,000)
  • Silver Creek – ($12,500)
  • Plum Falls – ($15,000)

This year Bob’s tenant offered to buy Whispering Pines for $250,000. He will have a gain on the sale totaling $100,000. Due to the gain from the sale of the property, all of the prior year’s suspended losses will be used in the current year. The $100,000 in gain will be offset by the suspended losses and current year losses, therefore he will pay tax on $59,000.

If you have rental properties and you need help or have questions come see us. At Bourke Accounting we are well versed in Passive Activities, give us a call today at 502-451-8773. See you soon!